One of the most memorable examples for me was in late 2007 ahead of the financial crisis when the credit markets had slammed shut after the initial Bear Stearns Hedge Fund problems in June followed by a run on the UK lender Northern Rock in September. Northern Rock was subsequently bailed out by the UK government. I was in charge of the Hedge Fund advisory business at a global investment bank which had just IPO'd a 'shadow banking' home lender which relied on the wholesale credit markets. The credit markets were effectively closed yet the equity market did not peak for another month afterwards [See chart below]. At the time I was reading about Jessie Livermore. This paragraph about Jessie Livermore stood out to me at the time..
"While his tape-reading skills were still important, they were not as important as studying the fundamentals of each company and the credit conditions of the stock market and the economy. His first successful “raid” on the stock market based on his sound, fundamental studies occurred during the Panic of 1907. As credit conditions tightened and as a number of businesses and Wall Street brokerages went bankrupt during the summer, Livermore could sense that something was wrong – despite the hopes of the public evident in the still-rising stock market. Sooner or later, Livermore concluded, there will be a huge break of epic proportions. Livermore continued to establish his short positions, and by October, the decline of the stock market started accelerating with the collapse of the Knickerbocker Trust in New York City and Westinghouse Electric. J.P. Morgan eventually stepped in to avert the collapse of the banking system and the New York Stock Exchange, but only after Livermore managed to make more than one million dollars by shorting the most popular stocks (and covering on a plea from J.P. Morgan himself) in the stock market."
At the time I wanted to learn more about this era and picked up the book 'The House of Morgan' by Ron Chenow which chronicled the history of J.P Morgan. A few chapters provided an excellent summary of the boom stock market in the late 1920's ahead of the ensuing crash and great depression.
During the 2009 Financial Crisis I wrote a note to my clients titled "How Will We Look Back on This Crisis". The note was a compilation of quotes from this 1990 book and while they referred to the 1920's and 1930's they were just as apt to the modern times. Consider the following ...
"Prophets of the age espoused an ideology of endless prosperity and talked of a new economic era"
The Fed's Greenspan and others, ahead of the Financial Crisis, were espousing the 'Great Moderation'. Greenspan presided over nearly two decades of prosperity and the lavish praise on the economy reflected the belief that Greenspan's deft changes in interest rates and crisis interventions stabilized the economy without rekindling inflation.
In his book 'The Most Important Thing' Howard Marks noted "On November 15, 1996 The Wall Street Journal reported on a growing consensus "From boardrooms to living rooms and from government offices to trading floors, a new consensus is emerging; The big, bad business cycle has been tamed."
"For many pundits, the sheer abundance of cash precluded any crash"
"There is a vast amount of money awaiting investment. Thousands of traders have been waiting for an opportunity to buy stocks on just such a break as has occurred over the last several weeks. The excess cash was viewed as a sign of wealth, not an omen of dwindling opportunities for productive investment".
Greenspan cut interest rates after the tech crash and left rates low which fuelled a rally in asset prices.
"Riding this cash boom, the American financial services industry grew explosively"
The American financial system also grew explosively ahead of the Financial Crisis. During the peak of the housing boom, in October 2007, the S&P Financials sector reached 20.1% of the S&P 500. Not even two years later in March 2009, that weighting had collapsed to 8.9%. That’s the same level as all the way back in 1989. The shadow banking market grew explosively also.
"There was a fad for foreign bonds, especially from Latin America, with small investors assured of their safety. The pitfalls were not exposed until later on, when it became known that Wall Street banks had taken their bad Latin American debt and packaged it in bonds that were sold through their securities affiliates"
Let's rephrase that … "There was a fad for mortgage backed bonds, especially from sub-prime borrowers with global investors assured of their safety. The pitfalls were not exposed until later on, when it became known that Wall Street banks had taken their bad mortgage debt and packaged it in bonds that were sold through their securities affiliates"
"The 1920s were also a time of manic deal making. As Otto Kahn recalled, there was a perfect mania of everybody trying to buy everybody else's property .. new organisations sprung up. Money was so easy to get. The public was so eager to buy equities and pieces of paper that money was .. pressed upon domestic corporations as upon foreign governments"
Let's rephrase that … "The years leading into the Financial Crisis were also a time of manic deal making. There was a perfect mania of everybody trying to buy everybody else's property .. new organisations sprung up. Money was so easy to get. The private equity funds were so eager to buy equities and pieces of paper that money was .. pressed upon domestic corporations as upon foreign governments"
"Wall Street was being swept by new forms of leveraging… many brokerage houses, including Goldman Sachs, introduced leveraged mutual funds, called "investment trusts". A second favourite device was the holding company. Holding companies would take over many small operating companies and use their dividends to pay off their bond holders, who had financed the takeovers in the first place. This permitted an infinite chain of acquisitions"
Wall Street was awash with new forms of leveraging before the Financial Crisis. RMBS's, CDO's, CDS, SIV's, PIK loans and many other types of credit derivatives were growing exponentially. In April 2007, The Economist noted "According to the Bank for International Settlements, the nominal amount of credit-default swaps had reached $20 trillion by June last year. With volumes almost doubling every year since 2000, some reckon the CDS market will soon be worth more than $30 trillion. The investment banks and private equity firms were up to their eyeballs in debt fuelled acquisitions.
"As masters of leverage, the Van Sweringens used